Question 1

Bondholders tend to offset the effects of selfish strategies implemented by shareholders by:

Accepted Answer

A) restructuring their loans to provide additional time to the firm to make repayment. 
B) subordinating their bankruptcy position to the shareholders. 
C) agreeing to reduce the outstanding principal balances on their loans. 
D) agreeing to reduce the interest rate on existing loans. 
E) increasing the interest rate on monies loaned to the firm. 
A) restructuring their loans to provide additional time to the firm to make repayment. 
B) subordinating their bankruptcy position to the shareholders. 
C) agreeing to reduce the outstanding principal balances on their loans. 
D) agreeing to reduce the interest rate on existing loans. 
E) increasing the interest rate on monies loaned to the firm.

Question 2

Mary owns 100 percent of a gift shop with an equity value of $150,000.If she keeps the shop open 5 days a week,EBIT is $75,000.If the shop remains open 6 days a week,EBIT increases to $92,000 annually.Mary needs an additional $50,000 which she can raise today by either selling stock or issuing debt at an interest rate of 7 percent.The principal amount would be repaid in equal annual payments at the end of the next five years.Ignore taxes.What will be the cash flow for the next year to Mary if she issues stock to another individual,remains open 5 days a week,and distributes all the residual cash flow to the shareholders?

Accepted Answer

A) $92,000 
B) $61,333 
C) $69,000 
D) $42,000 
E) $56,250 
A) $92,000 
B) $61,333 
C) $69,000 
D) $42,000 
E) $56,250

Question 3

Assuming the interest on the debt is fully tax deductible,when firms issue more debt,the present value of the tax shield on debt ________ while the present value of the financial distress costs ________.

Accepted Answer

A) decreases; decreases 
B) increases; increases 
C) decreases; remains constant 
D) decreases; increases 
E) increases; remains constant 
A) decreases; decreases 
B) increases; increases 
C) decreases; remains constant 
D) decreases; increases 
E) increases; remains constant

Question 4

Mary owns 100 percent of a gift shop with an equity value of $150,000.If she keeps the shop open 5 days a week,EBIT is $75,000.If the shop remains open 6 days a week,EBIT increases to $92,000 annually.Mary needs an additional $50,000 which she can raise today by either selling stock or issuing debt at an interest rate of 7 percent.The principal amount would be repaid in equal annual payments at the end of the next five years.Ignore taxes.What will be the cash flow for the next year to Mary if she issues stock to another individual,remains open 6 days a week,and distributes all the residual cash flow to the shareholders?

Accepted Answer

A) $58,750 
B) $61,333 
C) $92,000 
D) $42,000 
E) $69,000 
A) $58,750 
B) $61,333 
C) $92,000 
D) $42,000 
E) $69,000

Question 5

Mary owns 100 percent of a gift shop with an equity value of $150,000.If she keeps the shop open 5 days a week,EBIT is $75,000.If the shop remains open 6 days a week,EBIT increases to $92,000 annually.Mary needs an additional $50,000 which she can raise today by either selling stock or issuing debt at an interest rate of 7 percent.The principal amount would be repaid in equal annual payments at the end of the next five years.Ignore taxes.What will be the cash flow for the year to Mary if she issues debt,remains open 5 days a week,and distributes all the residual cash flow to the shareholders?

Accepted Answer

A) $46,125 
B) $61,500 
C) $65,000 
D) $71,500 
E) $67,880 
A) $46,125 
B) $61,500 
C) $65,000 
D) $71,500 
E) $67,880

Question 6

Which three factors are generally considered to be the most important when determining a target debt-equity ratio?

Accepted Answer

A) Taxes,asset types,and inflation rate 
B) Asset types,current operating income,and inflation rates 
C) Taxes,current operating income,and future operating income 
D) Taxes,asset types,and uncertainty of operating income 
E) Interest rates,inflation rates,and tax rates 
A) Taxes,asset types,and inflation rate 
B) Asset types,current operating income,and inflation rates 
C) Taxes,current operating income,and future operating income 
D) Taxes,asset types,and uncertainty of operating income 
E) Interest rates,inflation rates,and tax rates

Question 7

Conflicts of interest between stockholders and bondholders are known as:

Accepted Answer

A) trustee costs. 
B) financial distress costs. 
C) dealer costs. 
D) agency costs. 
E) underwriting costs. 
A) trustee costs. 
B) financial distress costs. 
C) dealer costs. 
D) agency costs. 
E) underwriting costs.

Question 8

One of the indirect costs of bankruptcy is the incentive toward underinvestment.Underinvestment generally would result in:

Accepted Answer

A) the firm selecting all projects with positive NPVs. 
B) the firm turning down positive NPV projects that would clearly be accepted if the firm were all-equity financed. 
C) bondholders contributing the full amount of any new investment,but both stockholders and bondholders sharing in the benefits of those investments. 
D) shareholders making decisions based on the best interests of the bondholders. 
E) the firm accepting more projects than it would if the probability of bankruptcy was ignored. 
A) the firm selecting all projects with positive NPVs. 
B) the firm turning down positive NPV projects that would clearly be accepted if the firm were all-equity financed. 
C) bondholders contributing the full amount of any new investment,but both stockholders and bondholders sharing in the benefits of those investments. 
D) shareholders making decisions based on the best interests of the bondholders. 
E) the firm accepting more projects than it would if the probability of bankruptcy was ignored.

Question 9

The optimal capital structure has been achieved when the:

Accepted Answer

A) debt-equity ratio is equal to 1. 
B) weight of equity is equal to the weight of debt. 
C) cost of equity is maximized given a pretax cost of debt. 
D) debt-equity ratio is such that the cost of debt exceeds the cost of equity. 
E) present value of the financial distress costs equals the present value of the tax shield on debt. 
A) debt-equity ratio is equal to 1. 
B) weight of equity is equal to the weight of debt. 
C) cost of equity is maximized given a pretax cost of debt. 
D) debt-equity ratio is such that the cost of debt exceeds the cost of equity. 
E) present value of the financial distress costs equals the present value of the tax shield on debt.

Question 10

Studies have found that firms with large investments in tangible assets tend to have:

Accepted Answer

A) higher financial distress costs than firms with comparable investments in intangible assets. 
B) zero debt. 
C) higher target debt-equity ratios than firms that primarily invest in intangible assets. 
D) the highest financial distress costs of any firm per dollar of debt. 
E) the same capital structure as firms that specialize in intangible asset investments. 
A) higher financial distress costs than firms with comparable investments in intangible assets. 
B) zero debt. 
C) higher target debt-equity ratios than firms that primarily invest in intangible assets. 
D) the highest financial distress costs of any firm per dollar of debt. 
E) the same capital structure as firms that specialize in intangible asset investments.

Question 11

Assume that for the next two weeks,the bondholders of Western Markets have the option of exchanging their bonds for common shares of the firm's stock.As a result of these exchanges,you should expect the firm's debt-equity ratio to:

Accepted Answer

A) decline and the stock's price to also decline. 
B) decline and the stock's price to remain constant. 
C) decline and the stock's price to increase. 
D) increase and the stock's price to increase. 
E) increase and the stock's price to remain constant. 
A) decline and the stock's price to also decline. 
B) decline and the stock's price to remain constant. 
C) decline and the stock's price to increase. 
D) increase and the stock's price to increase. 
E) increase and the stock's price to remain constant.

Question 12

LDL Transport is subject to claims from four parties as follows: tax claims = $6,740; bondholder claims = $28,520; bankruptcy claims = $4,300; and shareholder claims = $33,190.What is the total value of the marketed claims?

Accepted Answer

A) $61,710 
B) $33,190 
C) $72,750 
D) $39,560 
E) $66,010 
A) $61,710 
B) $33,190 
C) $72,750 
D) $39,560 
E) $66,010

Question 13

Ignore financial distress costs.When [(1 − TC)× (1 − TS)= (1 − TB)],then firms:

Accepted Answer

A) should be all-equity financed. 
B) need to maintain a debt-equity ratio of .5. 
C) tend to be indifferent between issuing debt or issuing equity. 
D) discover that both dividends and interest payments are non-deductible business expenses. 
E) can reduce their taxes by increasing their dividend payouts. 
A) should be all-equity financed. 
B) need to maintain a debt-equity ratio of .5. 
C) tend to be indifferent between issuing debt or issuing equity. 
D) discover that both dividends and interest payments are non-deductible business expenses. 
E) can reduce their taxes by increasing their dividend payouts.

Question 14

The Supply Depot is considering issuing $1 million in bonds but their financial staff has advised that if they do,the value of the firm will decrease.Given this advice,you know the staff believes the firm:

Accepted Answer

A) currently is all-equity financed and adding debt will cause a decrease in firm value. 
B) wants to issue too few bonds to obtain the most benefit from debt. 
C) will suffer from a decrease in its WACC if the bonds are issued. 
D) is at,or has exceeded,its optimal debt-equity ratio. 
E) will realize greater tax benefits by issuing equity securities. 
A) currently is all-equity financed and adding debt will cause a decrease in firm value. 
B) wants to issue too few bonds to obtain the most benefit from debt. 
C) will suffer from a decrease in its WACC if the bonds are issued. 
D) is at,or has exceeded,its optimal debt-equity ratio. 
E) will realize greater tax benefits by issuing equity securities.

Question 15

The explicit costs,such as the legal expenses,associated with corporate default are classified as:

Accepted Answer

A) debt flotation costs. 
B) beta conversion costs. 
C) direct costs of financial distress. 
D) indirect bankruptcy costs. 
E) unlevered costs of capital. 
A) debt flotation costs. 
B) beta conversion costs. 
C) direct costs of financial distress. 
D) indirect bankruptcy costs. 
E) unlevered costs of capital.

Question 16

Which one of the following is not implied by the pecking order theory?

Accepted Answer

A) Profitable firms tend to use less debt than unprofitable firms. 
B) Companies like having financial slack. 
C) Companies prefer to borrow up to the point where the financial distress costs offset the tax benefit of debt. 
D) There is no target debt-equity ratio for a firm. 
E) Firms tend to accumulate cash in anticipation of future projects. 
A) Profitable firms tend to use less debt than unprofitable firms. 
B) Companies like having financial slack. 
C) Companies prefer to borrow up to the point where the financial distress costs offset the tax benefit of debt. 
D) There is no target debt-equity ratio for a firm. 
E) Firms tend to accumulate cash in anticipation of future projects.

Question 17

In a world with taxes and financial distress,when a firm is operating with the optimal capital structure the:

Accepted Answer

A) debt-equity ratio will be minimized. 
B) weighted average cost of capital will be maximized. 
C) firm will be all-equity financed. 
D) required return on assets will be at its maximum point. 
E) overall benefits of debt have all been realized. 
A) debt-equity ratio will be minimized. 
B) weighted average cost of capital will be maximized. 
C) firm will be all-equity financed. 
D) required return on assets will be at its maximum point. 
E) overall benefits of debt have all been realized.

Question 18

What is the pecking order theory and what are the implications that arise from this theory?

Accepted Answer

The pecking order theory states that fir

Question 19

Assume CRT debtholders are promised payments in one year of $35 if the firm does well and $20 if the firm does poorly.There is a 50/50 chance of the firm doing well or poorly.If debtholders are willing to pay $25.50 today to purchase this debt,what is the promised return to those debtholders?

Accepted Answer

A) 7.3 percent 
B) 6.8 percent 
C) 1.7 percent 
D) 7.8 percent 
E) 8.2 percent 
A) 7.3 percent 
B) 6.8 percent 
C) 1.7 percent 
D) 7.8 percent 
E) 8.2 percent

Question 20

Which one of these represents a difference between business entities in Japan and in the United States?

Accepted Answer

A) Lenders in Japan frequently also take ownership positions in firms to which they lend. 
B) Debt-equity ratios tend to be higher in the U.S.than they are in Japan. 
C) There tends to be greater agency issues between stockholders and bondholders in Japan as compared to the U.S. 
D) Bondholders in Japan are prohibited from also being shareholders in the same firm. 
E) The debt-equity ratios for firms in Japan and in the U.S.tend to be relatively equal. 
A) Lenders in Japan frequently also take ownership positions in firms to which they lend. 
B) Debt-equity ratios tend to be higher in the U.S.than they are in Japan. 
C) There tends to be greater agency issues between stockholders and bondholders in Japan as compared to the U.S. 
D) Bondholders in Japan are prohibited from also being shareholders in the same firm. 
E) The debt-equity ratios for firms in Japan and in the U.S.tend to be relatively equal.

Exam 17: Capital Structure: Limits to the Use of Debt

Bondholders tend to offset the effects of selfish strategies implemented by shareholders by:

Assuming the interest on the debt is fully tax deductible,when firms issue more debt,the present value of the tax shield on debt ________ while the present value of the financial distress costs ________.

Which three factors are generally considered to be the most important when determining a target debt-equity ratio?

Conflicts of interest between stockholders and bondholders are known as:

One of the indirect costs of bankruptcy is the incentive toward underinvestment.Underinvestment generally would result in:

The optimal capital structure has been achieved when the:

Studies have found that firms with large investments in tangible assets tend to have:

Assume that for the next two weeks,the bondholders of Western Markets have the option of exchanging their bonds for common shares of the firm's stock.As a result of these exchanges,you should expect the firm's debt-equity ratio to:

LDL Transport is subject to claims from four parties as follows: tax claims = $6,740; bondholder claims = $28,520; bankruptcy claims = $4,300; and shareholder claims = $33,190.What is the total value of the marketed claims?

Ignore financial distress costs.When [(1 − TC)× (1 − TS)= (1 − TB)],then firms:

The Supply Depot is considering issuing $1 million in bonds but their financial staff has advised that if they do,the value of the firm will decrease.Given this advice,you know the staff believes the firm:

The explicit costs,such as the legal expenses,associated with corporate default are classified as:

Which one of the following is not implied by the pecking order theory?

In a world with taxes and financial distress,when a firm is operating with the optimal capital structure the:

What is the pecking order theory and what are the implications that arise from this theory?

Assume CRT debtholders are promised payments in one year of $35 if the firm does well and $20 if the firm does poorly.There is a 50/50 chance of the firm doing well or poorly.If debtholders are willing to pay $25.50 today to purchase this debt,what is the promised return to those debtholders?

Which one of these represents a difference between business entities in Japan and in the United States?

Introduction to Corporate Finance

Financial Statements and Cash Flow

Financial Statements and Cash Flow

Discounted Cash Flow Valuation

Net Present Value and Other Investment Rules

Making Capital Investment Decisions

Risk Analysis, real Options, and Capital Budgeting

Interest Rates and Bond Valuation

Stock Valuation

Lessons From Market History

Return, risk, and the Capital Asset Pricing Model Capm

An Alternative View of Risk and Return: the Arbitrage Pricing Theory

Risk, cost of Capital, and Valuation

Efficient Capital Markets and Behavioral Challenges

Long-Term Financing

Capital Structure: Basic Concepts

Valuation and Capital Budgeting for the Levered Firm

Dividends and Other Payouts

Raising Capital

Leasing

Options and Corporate Finance

Options and Corporate Finance: Extensions and Applications

Warrants and Convertibles

Derivatives and Hedging Risk

Short-Term Finance and Planning

Cash Management

Credit and Inventory Management

Mergers,acquisitions,and Divestitures

Financial Distress

International Corporate Finance

Filters

Assuming the interest on the debt is fully tax deductible,when firms issue more debt,the present value of the tax shield on debt while the present value of the financial distress costs .

Ignore financial distress costs.When [(1 − T_C)× (1 − T_S)= (1 − T_B)],then firms: